Reverse mortgages are usually advertised as an ideal way for senior citizens to get extra spending money to supplement their retirement income. But taking out a reverse mortgage is not always a good idea.
How Reverse Mortgages Work
A mortgage is an agreement between a lender and a homeowner, in which the homeowner borrows against the home’s equity. In a regular mortgage, the owner gets a lump sum from the lender, and makes monthly payments towards paying the money back, including interest. In a reverse mortgage, rather than obtaining a lump sum that has to be steadily paid back, the owner typically receives periodic payments from the lender, which become the loan. The loan amount grows every time the lender sends a payment, until the maximum loan amount has been reached. The homeowner doesn’t have to repay the loan unless and until specified events happen, as explained below.
Sound too good to be true? Many would agree, because in the end, the lender usually gets its money back, and more—why else would it engage in this business practice? The balance of this article explains in more detail how reverse mortgages work, their limitations, and the advantages and disadvantages to consumers.
Dollar Limits to Reverse Mortgages
Almost all reverse mortgages are Home Equity Conversion Mortgages (HECMs), which are federally insured through the Federal Housing Administration (FHA). This insurance program is not set up to benefit the homeowner—it’s for the benefit of the lender. The insurance will step up if you default on your loan (you breach the mortgage agreement) or the loan is accelerated (called due) for some other reason, but your house isn't worth enough to fully repay the debt through a foreclosure sale. If this happens, the FHA will compensate the lender for the loss.
Generally, homeowners who are over age 62, occupy the property as their principal residence, and have 50-55% or more equity in their home will likely qualify for a reverse mortgage under the HECM program. However, the most money you can get with a HECM is $636,150 (as of January 1, 2017)—no matter how much equity you have in your home.
Jumbo Reverse Mortgages
Jumbo reverse mortgages are available only to homeowners with very high-value homes, and are not very common. While a FHA-insured reverse mortgage can’t be more than $636,150, a jumbo reverse mortgage loan can be as much as several million dollars. But unlike an HECM mortgage, a jumbo is not federally insured. This means that the lender does not have the federal government at the ready to make up for the difference between the home’s sale value and the higher amount of the outstanding loan, should the lender have to foreclose in order to get paid. As a consequence, jumbo mortgages are more expensive.
How the Lender Distributes Funds
You can choose to have reverse mortgage funds distributed as:
- a lump sum (full or partial)
- monthly payments
- a line of credit, or
- any combination of these options.
Before 2013, borrowers could take out 100% of the principal limit all at once. This led to problems for many borrowers in the following years, because they’d used up the equity in the home and couldn’t get more money or another loan. Now, federal law limits the amount you can borrow in the first year of the loan to the greater of 60% of your approved loan amount or the sum of the mandatory obligations plus 10% of the principal limit. Mandatory obligations include, for example, existing mortgages and other liens on the property.
For example, if you have no mandatory obligations (like liens or an existing mortgage) and qualify for a $100,000 reverse mortgage, you can get only $60,000 in the first year. If you take out the reverse mortgage as a one-time lump sum, you forfeit the rest of the available principal ($40,000). However, you can choose a partial lump sum and get the rest of the available principal as a line of credit or monthly payments.
If you have mandatory obligations, you can get more money to pay those off. So, if you have $70,000 of mandatory obligations (for example, an existing mortgage and a lien) and qualify for a $100,000 reverse mortgage, you can get $80,000 in the first year. Here’s how the math works:
Mandatory obligations: $70,000
10% of the principal limit ($100,000 x .10 = $10,000): $10,000
The borrower gets $10,000 and $70,000 goes to pay off the existing mortgage and lien.
Reverse Mortgage Requirements
Under the terms of a reverse mortgage, you must continue to pay the property taxes and homeowners’ insurance. Why is the lender concerned about these matters? Remember, if you can’t repay the loan, it will sell the house to satisfy the debt (foreclose on it). A house that is free of tax liens and in good shape because insurance money was available, for example, to rebuild following a fire, will fetch more money than one saddled with liens and left to deteriorate.
To make sure you can stay current on taxes and insurance, the lender assesses the homeowner’s financial situation when considering a reverse mortgage. If the lender determines you probably won’t be able to stay current on these expenses, it establishes a set-aside account as part of the reverse mortgage. A set-aside account is an amount of money (part of the loan) that the lender keeps to pay the taxes and insurance in the upcoming years. If you have a set-aside account, you get less money from the reverse mortgage.
Under the terms of the reverse mortgage, you also have to maintain the home in good condition and pay your HOA fees (if your community requires them). The lender is not taking any chances on the healthiness of the house’s title or its physical condition.
Tellingly, you must also complete a counseling session with an FHA-approved counselor. The purpose of the counseling session is to make sure that you understand what you’re getting into. Reverse mortgages are extremely complicated. HECM counselors have reported that it typically takes at least two hours to explain how these mortgages work and cover all of the topics (such as the costs and consequences) that borrowers need to understand before taking out a reverse mortgage. Even after a long counseling session, many borrowers still don’t fully understand all of the reverse mortgage terms and requirements.
When You Have to Repay the Loan
You have to repay a reverse mortgage when one of the following happens:
- The home is no longer your principal place of residence. (You may still own the home, but you live elsewhere most of the time). As soon as your principal place of residence has changed, the lender theoretically can call the loan.
- You move out because of a physical or mental illness, and you’ve been gone for more than 12 consecutive months. This provision takes into account the experience of many seniors, who enter short-term rehabilitation facilities but recover sufficiently to return home.
- You sell the home.
- You transfer the home’s title (ownership) to someone else, or
- You pass away.
Upsides to a Reverse Mortgage
Reverse mortgages offer some advantages. For one thing, if you’re equity-rich but cash-poor, a reverse mortgage might be a good way to get extra spending money.
Other advantages to reverse mortgages include:
- HECM’s are nonrecourse, which means the lender can’t come after you or your estate for a deficiency judgment after a foreclosure. When a lender sells a home as part of a foreclosure in a normal mortgage situation, the proceeds from the sale pay off the loan. If the home does not sell for enough to fully repay the debt, the difference between the total debt amount and the sale price is called the deficiency. Depending on state law and the circumstances, the lender might be able to get a deficiency judgment from a court, which makes the borrower personally responsible to pay the deficiency—but not in the case of a HECM. Jumbo reverse mortgages are sometimes nonrecourse, but not always.
- As long as you live in the home and don’t break the terms of the reverse mortgage agreement, you don’t have to make any payments on the loan.
Downsides to a Reverse Mortgage
While there are some upsides to reverse mortgages, there are also significant drawbacks. For example, if you don’t pay the property taxes or homeowners’ insurance, fail to keep the property in reasonable shape, or breach any of the other mortgage requirements, the lender can foreclose. A reverse-mortgage lender once started a foreclosure because a 90-year-old woman failed to pay the $0.27 needed to get current on her homeowners’ insurance. This was not an isolated incident. Reverse mortgage lenders have a reputation for foreclosing on elderly homeowners for relatively minor mortgage violations.
Reverse mortgages are designed so that the lender ends up with the home. Even if you do everything you’re supposed to under the mortgage agreement, you probably won’t have money or equity left when the loan comes due and you’ll likely lose the home to foreclosure.
Other downsides to reverse mortgages include:
- If you get become ill and move into a care facility (like a nursing home), the lender can call the loan due once you’ve been gone from the home for more than a year. You’ll then have to pay back the loan or the lender will foreclose.
- The reverse mortgage could affect your eligibility for Medicaid. For example, because you can’t have more than a certain amount of money under that program, receiving reverse mortgage funds each month could push you over the limit.
- The fees on a reverse mortgage might be higher than a regular mortgage.
- The more money you get from a reverse mortgage, the less equity you have in the home. So, you’ll have fewer assets to leave to your heirs. You can still leave the home to your heirs, but they’ll have to repay the loan.
How Lenders Make Money with Reverse Mortgages
Having read about the terms and conditions of a reverse mortgage, you can see that the lender will eventually be paid back for its monthly loans to the homeowner. If the homeowner can’t repay the loan, the lender sells the property and satisfies the loan out of the sale price; and if the sale price is insufficient and the mortgage is federally-insured, the federal government makes up the difference. At the very least, the lender has made back its principal, plus interest and fees.
Because you get money now and don’t have to pay it back until much later (theoretically), a reverse mortgage might initially sound very appealing. But, because of the drawbacks associated with these loans, it’s a good idea to consider other options if you’re facing financial difficulties. For example, you could:
- sell the home and downsize
- apply for federal, state, or local programs that provide grant money or other financial assistance to seniors (such as for utilities or home repair), or
- apply for property tax credits or abatements (reductions). Many jurisdictions provide tax relief options for the elderly.
If, after considering all the downsides to reverse mortgages you’re still thinking about getting one, consider talking to a financial planner or elder-law attorney first. For more general information about reverse mortgages, go to the AARP website.